Sliding Iron (12-16-11)

A slump in China’s real estate, auto, rail and household appliance markets, coupled with a flailing Eurozone has led to very soft global demand for steel. All the while, global miners Rio Tinto, Vale and BHP have continued to ramp up production, which may mean a short-term glut in ore supply until demand catches back up. Traders will likely respond to the news by shorting global miners in the short term, but going long in 2020 when developing economies and the Eurozone recover. Expect more industry consolidation as smaller ore providers fail to weather the storm.

Mayan Predictions for Iron Ore

BHP’s stock has fallen 24% this year. Rio Tinto is down 33%. Investors are nervous for good reason; China – the world’s leading producer of steel – is loosing steam. 2012 is going to be a very bad year for iron ore.

China is able to supply 40% of its iron ore needs with domestic reserves, but the rest needs to be imported. In importing the other 60%, China consumes about half of the traded world supply of iron ore each year. This colossal demand for red earth allows the country to generate about 46% of the world supply of crude steel - approx. 700 million tons for 2011. About half of this output is pumped directly into the construction of domestic infrastructure.

With the Eurozone in a tailspin and the US a sneeze away from sickness, the world is importing less Chinese steel. As a result, China will have to swallow unprecedented volumes of its own products with fixed asset investment in order to maintain growth necessary for China to stay above 8% GDP growth. China needs to see strong growth in the major downstream industries of construction, autos, rail, durable goods and machine tools if it stands a chance of offsetting losses from exports to plunging western peers.

Q4 data has revealed a downturn in China’s real estate market. Sales and prices have taken a plunge, resulting in halted construction projects and a significant drop in land auctions to real estate developers. A drop in land sales has meant a natural decrease in new construction projects and a subsequent decrease in steel demand from this sector.

The government’s goal is to have 10 million units of government assisted housing under construction by the end of 2011. Some analysts say that the investment coming from this project will offset the slump in demand from floundering commercialized properties. However, a significant portion of the steel used in these projects will come from China’s 14 million ton stockpile of excess steel. Indeed, soaking up this excess was one of the factors that motivated the creation of this policy in the first place. If we assume that each unit of government assisted housing is 50 square meters, and each square meter consumes 50 kilograms of reinforcing steel bars, then the 10 million units set to begin construction this year will generate a demand for 25 million tons of raw steel materials. If 14 million tons come from China’s excess stock, then there will only be new demand of 11 million tons, or less than 1.6% of the country’s annual production capacity.

When you run the numbers, you find that for every 1% decrease in the construction of China’s infrastructure, the global demand for internationally traded iron ore drops by about 0.7%. Of course, apartments that aren’t built don’t need to be furnished with ovens and refrigerators, and so softened investment in fixed assets today will translate to weakened demand for steel to build household appliances tomorrow. Less apartment buildings also means a weakened appetite for Japanese and South Korea specialty steel. China imports roughly 6% and 7% of these countries total crude steel output, respectively. The immediate impact of a 1% slowdown may only be -0.7%, but the long-term impacts are far more severe.

If less steel is going into housing, and less steel will be required for durable consumer goods, then that leaves autos and rail pick up the slack. According to the CISA, between 50 and 60% of the weight of a typical car is made up of steel and a further 12 to 15% comprises cast iron. In the years following the financial crisis, the Chinese government spurred industrial growth with a series of policies stimulating the purchase of autos. Sales reached a climax in January 2010, seeing numbers as extreme as 124% growth month-over-month. Consumers, knowing that the tax breaks were set to expire, made their 2011-2012 purchases in 2010. Once the party ended, the hangover set in; October is historically a strong month for the industry, but sales YoY sales were negative this year for the first time, ever. China’s auto industry is in a slump, and will not need new steel production capacities any time soon.

Rail isn’t doing any better. A high-speed rail crash on July 23 followed by a number of accidents and industry scandals have caused the government to halt the construction of a number of new rail lines pending thorough investigations. Not only does this mean a greatly diminished demand for steel from the rail industry, but it also means that China is no closer to solving the problem of massive coal shortages caused by transportation bottlenecks. Already, 60% of all freight movements in China are solely for the transportation of coal. Many of China’s steel mills have had to relocate to the eastern seaboard to circumvent the rail issue and import its anthracitic coal directly from Australia. Wage rates are significantly higher in these areas, though, and coal prices are destined to see a seasonal spike over the winter, as China is still 68% dependent on coal for energy. These factors will spell a very hard year for a steel sector already struggling with profit margins of less than 3%.

Rock and a Hard Place

Government policies will finish what waning downstream demand has started. According to the most recent rounds of government policies, the goals for the steel industry is to destock, consolidate and upgrade. The Ministry of Environmental Protection and the Ministry of Industry and Information Technology have launched new stringent requirements for the reduction of pollutant emissions and energy consumption. China’s steel industry will have to eliminate many outdated production capacities, and invest a large sum of capital to renovate and upgrade.

At the same time that demand is declining, the industry will be ousting outmoded production capacities to meet China’s New Environmental Production Standards. This process will eventually restructure the industry to create a small number of massive players capable of churning out large volumes of a high-tech product mix. In the short term, though, industry output will be stagnant for at least the next year, meaning that there will definitely be no increase in China’s demand for iron ore any time soon.

Bullish Plans for a Bearish Decade

The CISA has forecasted that the growth of China’s demand for steel will slow to just 2.6% YoY by 2015, down from this year’s 4.6% YoY growth. November data showed a crude steel output of just 49.88 million tons – the lowest production in 14 months. Aussie giants Rio Tinto and BHP have responded to this news with the counterintuitive approach of ballooning their mining operations. Rio’s board has just approved a USD 14 billion budget for 2012 mining projects, up from this year’s budget of USD 12 billion. BHP is looking at similar expansion plans, and has earmarked more than USD 80 billion to invest in major projects and exploration by 2015. Sam Walsh, director of Rio Tinto’s iron ore division has stated that the mining industry goal is to increase iron ore supply by 100 million tons per year until 2020.

With supply ballooning and demand waning, prices have naturally taken a massive tumble. Iron ore spot prices fell 24% from early September to mid-December. A recent report from Reuters has stated that the plunge of spot market prices for iron ore and lukewarm tenders have indicated that the spot market is likely to drop further throughout the month. Steel mills, expecting additional price drops, are hesitating to purchase ore. As a result, stock of imported iron ore at Chinese ports have been hovering around 100 million tons, up from the usual volume of 70 million tons. Of course, this hesitation has become a self-fulfilling prophecy, and prices have continued to drop throughout December.

China Spot Index (CSI) for Iron Ore

Blue: Spot Prices for Imported Iron Ore with 62% Iron Ore Content

Red: General Index for Imported Powdered Ore

This dynamic will be awful for iron ore providers in the short term, but may have an eventual payoff. The “global miners” Rio Tinto, Vale and BHP Billiton are effectively an oligopoly that account for nearly 70% of the global trade of iron ore. China has a total of 77 large- and middle-sized steel mills that in 2010 posted net profits of RMB 89.7 billion. By contrast, 2010 profits for the three global miners more than tripled this figure.

The result of all of this money is that these giants are able to weather any storm. In flooding a waning market with a glut of commodities, these companies stand to take heavy losses. Indeed, recent reports show that BHP’s stock has fallen 24% this year. Rio Tinto is down 33%. However, the long-term benefit of this strategy is easy to see – the flood of ore into the market will strangle out smaller competitors. When the red dust settles in 2020, these companies will loom larger than ever with massive capacities to feed a rebounding India and a mature, technologically advanced China.

"If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com

Pop Goes the Bubble (12-5-11)

What a difference a month makes. China’s central government has popped its own real estate bubble, trading the nameplate wealth of its middle class and local government revenues in the short-term for more sustainable urbanization and job creation in the mid-term. While this will not evolve into a financial crisis for China, there is a 25% probability that local governments will receive a bailout before 2015 to maintain solvency.

Stoking the Fire

A massive real estate bubble has been looming ominous in China. The bubble has been most apparent in the cities of Ordos and Wenzhou where speculation is most extreme. In these areas, private lending networks have given investors quick and quiet access to loans to invest in speculative real estate projects. In the beginning, many residents became overnight millionaires, stoking local appetites for risky bets. A survey conducted in October showed that in Wenzhou, 60% of local businesses and 89% of households were tied together with outstanding private loans totaling RMB 120 billion, most of which has been invested in local real estate development projects.

Easy access to unofficial loans caused the hyperinflation of a real estate bubble, boosting the price of commercial real estate in Ordos by more than 1,600% since 2005. According to a survey done in October, the average household in Ordos owns three condos – an investment phenomenon that has produced 168 empty high-rises in this city, alone. Ordos only has one-tenth the population of Beijing, but still managed to sell two-thirds the square footage of real estate in 2010, 98% of which was previously unoccupied.

Although less extreme, a similar real estate bubble has been growing in the first-tier cities of Shanghai, Beijing, Shenzhen and Guangzhou. In Shanghai, real estate prices have risen more than 150% since 2003, and the average apartment is now more than 40 times the annual income of the average citizen. In Beijing, growth in real estate prices have outpaced increases in income by more than 80 percentage points per year since 2005. The middle class fueled much of this growth, viewing investment in real estate as a much safer bet than bank deposits or playing the stock market.

“I Love Government Assisted Housing… I Have Three of Them!”

The proportion of migrant workers to residents in the first-tier cities of Beijing, Shanghai and Guangzhou is more than 3:10. In Shenzhen, it is more than 7:10.  Sky-high real estate prices have created a massive barrier to entry for impoverished newcomers looking to settle down. The Chinese government has stated in its 12^th Five-Year Plan that level of urbanization will increase from the current 47.5% to 51.5% by 2015. China’s real estate bubble is not only a threat to its banks, but also threatens the country’s rate of urbanization. Less migration into China’s cities will mean less job creation, and for every million jobs lost, China forfeits one percentage point from its GDP growth.

In order to reach 51.5% urbanization, an additional 53.6 million people will have to move into urban areas by 2015. The average Chinese household has 3.3 members, meaning that new urban residents will generate a demand for 16 million additional housing during this period. Not only will China have to construct 16 million housing units in its cities, but it will also have to guarantee that the vast majority of these units are within the price range of a migrant laborer. The government has decided to inject 36 million units of government-assisted housing into the system over the next five years. This is more housing than the US has constructed since 1986. But how to keep these units safe from investors and market speculation?

The End of the Party

In the interest of urbanization and job creation, China popped its own bubble. In 2010, China intensified a series of restrictive purchasing policies in first tier cities, making it nearly impossible to buy non-owner occupied investment housing. Loans to first-time and second-time buyers of commercial housing now required deposits of 30% and 50%, respectively with base interest rates of no less than 10%. Households wishing to purchase a third unit of real estate are now ineligible for a bank loan. The policy also ended loans to non-residents unable to provide certification of paying one year of the city’s taxes and social security dues.

Inflationary pressures finished what restrictive policies started. Chinese citizens are currently squeezed in the triple vice of domestic inflation, an appreciating RMB and waning demand from a collapsing Eurozone. Indeed, China’s PMI for November was 52.5, down from 54.1 in October. Global PMI for the month was down to 49.6 showing a worldwide contraction in manufacturing – not a good sign for China.

When properties stopped selling, some of China’s more fragile real estate networks simply collapsed. In September and October, Wenzhou and Ordos were found to be two canaries in a toxic coalmine. When the Wenzhou Public Security Bureau reported that more than 40 indebted local business owners had gone into hiding as of September 27, central authorities moved in to investigate. It was soon revealed that a network of bank tellers and low-ranking government officials with access to low-interest loans had been borrowing money and then re-lending it with usurious annual interest rates as high as 80%.

Sensing an impending market correction, China’s central authorities moved to make sure that workers got away unscathed. The government started pressing developers in mid-November to sell off properties at discount prices to settle land payments and return bank loans. Deyang Liu, chairman of the board at Savills, said in a recent interview that the central government has been “keeping a very close eye on the construction accounts of developers. They have been pressuring developers to lower prices and sell more units in order to settle these accounts at the end of the year.”

China’s leading developer Vanke responded to the call by lowering the prices of new units in Shanghai, Beijing, Shenzhen and Nanjing by 20%-30% on average. Developers across the country quickly parroted the move, causing a decrease in prices for over 80% of properties on the Shanghai market, alone. Many new homeowners were caught in the middle and lost most of their nameplate wealth overnight. They responded with a series of protests in the offices of real estate developers. Offices were destroyed, but the cries of the middle class fell on deaf ears in the central government.

Reason to Panic?

Thankfully, it appears unlikely that the burst of China’s real estate bubble will trigger a nationwide financial crisis. Tighter purchasing policies have resulted in a 30%-50% cushion for each housing loan issued by banks. Former chairman of the China Banking Regulatory Commission has stated that banks can withstand a 40% decline in housing prices while still maintaining a debt service coverage ratio (DSCR) of 110%. Should prices fall 50% or more, however, banks may become insolvent.

The market is likely to correct downwards between 20% and 30% over the next twelve months, but this will still leave banks with enough liquidity to weather the storm. In fact, Standard & Poor’s upgraded its ratings for Bank of China and China Construction Bank while dropping ratings for Bank of America, Goldman Sachs and Citigroup. On several occasions, S&P has cited the strong liquidity of the Chinese government and the high likelihood of government support in times of distress as reasoning for its high ratings. Clearly, S&P is on to something; the firm realizes that even if China’s banks take a hit from a bursting real estate bubble, the government will surely use its piles of foreign reserves to soften the landing.

Governing the Debt

The real losers will be local governments. Currently, local governments obtain approximately 1/3 of their revenues from land transfer fees obtained by selling development rights to real estate firms. The central government has mandated that 36 million housing units be built over the next five years, and local officials know that their contribution to this sum will have a substantial impact on their careers. Political gain will not come without a price, however, as government-assisted housing yields much lower returns than contracts for developing premium condos.

Local governments are already buried in debt from the 2008 stimulus package. As of 2010, local government debt totaled RMB 10.7 trillion, or 80% of total bank lending, according to statements made by Liu Mingkang of the CBRC. These institutions already stood to loose big with large portions of land being allocated to building homes for the poor. Now, with the market in a downturn, it seems unlikely that local governments will be able to auction off what little land they have left.

Indeed, a report from Centaline China Property Research has shown that in November, 117 plots of land failed to sell in land auctions, up more than 530% from the previous month. There has been a 14% decrease in land sales from the previous year’s totals of RMB 92.1. Plummeting land sales will mean a significant dip in local government revenue, threatening liquidity. If leading indices continue to fall, signaling a contraction of gross economic activity, China may again have to bail out its local governments to help them maintain solvency. I believe that there is a 25% probability that local governments will receive a bailout before 2015 to maintain solvency.

"If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com

Days Are Numbered for BYD After a Tough October (10-23-11)

A poor October for China's auto market and a growing appetite for domestic 

M&A may spell the end for Warren Buffett favorite BYD Autos.

Hard Times

The October numbers are in and they don’t look good. Last week, the China Association of Automobile Manufacturers (CAAM) released the auto sale and production figures for the month of October. China’s auto sales are down 7.37% relative to September 2011 and are showing a 1.07% drop YoY. Production, too, has fallen 1.99% relative to September figures. This is a first for China and a major shock for the industry. Since China’s State Information Center started recording the statistic in 2000, China has never before reported negative growth in October auto sales.

In April 2010, Chinese consulting firm AlixPartners released a survey in which 50 auto industry executives stated their expectation that China’s auto sales would continue to grow by 20% per annum over the next five years. This may have been a safe statement to make in 2010 when auto sales for January-October were up 35.03% relative to the same period in the previous year, but 2011 has shown only 3.47% growth over this period.

These plummeting figures are a shock for a number of China’s small domestic auto manufacturers, many of which have already been struggling to stay alive in an overcrowded and highly competitive industrial landscape. China’s auto industry is renowned as being the most dispersed in the world. According to the October figures reported by CAAM, China’s top 5 sedan manufacturers represented less than 44% of the month’s sedan sales. Not a single one of these five firms are indigenous to China. Indeed, in the list of China’s top ten firms ranked according to sedan sales for October, only two names (Chery and Geely) are domestic. The other eight companies are made up of joint enterprises in which Chinese members own a mere 51% stake.

Recognizing the need for stronger domestic players in the industry, the Chinese government has chummed the waters with a series of policies encouraging domestic mergers and acquisitions. The party has publically stated its goal to reduce major market players from 14 in 2010 to less than 10 by next year. When the music stops, a number of firms are going to loose their seats for good, and investors are lining up to make bets on who’s going to get the chop.

Warren Buffett’s Big Bet

In 2008, Chinese automaker Build Your Dreams (BYD) looked like a sound investment. Despite its obvious theft of auto designs from Hyundai and Toyota, BYD claimed a level of technological maturity that other Chinese firms had yet to achieve. Originally the world’s largest manufacturer of cell phone batteries, BYD has since set its sights on leading the world to a future of plug-in hybrids fueled by lithium-ion batteries. The proposition was so exciting, in fact, that Warren Buffett put USD 232 million into purchasing a 9.9% stake in the company.  

Electric plug-ins may have been a hot promise in 2008, but since this transaction took place, the company has yet to sell even 500 units of plug-in autos. The Joint Research Center of the European Commission reported in a document released in June 2010 that pure electric cars will “remain very limited until at least 2020” and that major barriers for large-scale market development will remain in place up to 2030.

Despite this lukewarm outlook for new energy autos in the short term, BYD has initiated a series of long-term investments in industrial parks all over China aimed at increasing its stake in solar cells, electric cars and recharging stations. This expansion is a big risk, and BYD is relying on auto revenues and government support to keep the company afloat until the investments mature. This aggressive expansion into new energy led to a spike in fixed asset investment, boosting the value of its fixed assets and plants under construction by nearly RMB 10 billion in 2010 – an increase of 51.32% YoY.

Build Your Nightmare

Many investors now fear that BYD chairman Chuanfu Wang has grown reckless after years of gorging himself on the government punch. In 2008, 2009 and 2010, government subsidies paid 12%, 10% and 28%, respectively, of the company’s reported annual net profits. Additional revenues came from government contracts placing orders for hundreds of e-buses and electric taxis for Chinese cities.

Even with the government boosting BYD’s books, the fact remains that recent investments were made under the presupposition that sales and profits would continue to trend upwards for years to come. On August 22, BYD released a report stating that auto sales for H1 2011 only reached 225,800 units, down 22% from H1 2010. Profits over the same period took a nosedive to the tune of 88.6%. Paired with this report was an announcement that BYD would be significantly reducing its auto sales staff from 2,600 employees to just 800. Employees pushed back, and 50 days later management was forced to enter labor negotiations under threat of government intervention.

With sales and profits sharply dropping and capital tied up in long-term investments in new energy, BYD’s liquidity and quick ratios have dropped far below those of industry competitors to values of just 0.63 and 0.4, respectively. New reports say that the company is paying off its mature bank loans with borrowed money. With the People’s Bank trending towards tighter monetary policies, BYD has been having an increasingly more difficult time getting access to new loans to pay off old debts.

BYD’s existing capital is tied up with local governments in unbreakable industrial park development contracts. Its profits are tanking as auto sales plummet. The company is also losing access to new loans to pay off its old debts. China has stated that at least three of its major auto firms will not survive past 2012. Somewhere, Warren Buffett is starting to sweat.

 "If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com